Should You Choose a Roth IRA Over a Traditional IRA for Retirement Savings?

It's a question investors have been asking themselves since 1998, when they were first given the choice. Is it better to forego a tax break now and fund a Roth IRA that offers tax-free withdrawals later? Or, does it make more sense to fund an ordinary "contributory" IRA with tax-deductible contributions, and pay taxes on distributions from this account in the future?

The fact that there's still no clear answer underscores the idea that it's a complicated matter. Fortunately, the overarching criteria to consider aren't complicated.

What's the difference between a traditional and Roth IRA?

If you're not familiar with the chief difference between a Roth IRA and a traditional IRA (also called an ordinary or contributory IRA), it's simple enough. Contributions to an ordinary IRA are tax-deductible for the tax year in which they're made, but future withdrawals from these accounts are taxed like ordinary income. This is in contrast with Roth IRAs, which are made with contributions that aren't tax-deductible. However, distributions from Roth accounts aren't taxable.

The only potential "catch" with a Roth is that you must qualify to fund one, and higher earners might not. Other than that, they're the same in that both kinds of retirement accounts allow for tax-free growth of the investments held inside them.

It's not just self-directed/self-funded IRAs that offer this choice. Most employers that offer a 401(k) savings plan also offer a Roth 401(k) option with the same taxability rules. That is, if you sidestep taxes now, you'll pay them later, or if you pay them now, you'll sidestep them later.

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So what's the right choice? In general, you should aim to minimize your total taxable income when your tax liability is at its highest, and take your tax lumps when your tax liability is at its lowest. For most people, the tax benefit will mean the most during their working years, since they'll likely be earning less income -- and, therefore, owe less taxes -- in retirement. In fact, it's possible you'll be in a completely different tax bracket between these two stages in life.

There are a couple of important footnotes to consider in the matter, however.

Your strategy should reflect all details, current and future

Yes, it can take some guesswork to determine your future income. How much longer you work, how much your nest egg grows in the meantime, and how your work-based income is apt to change before you retire are all factors in the matter, none of which are etched in stone.

If you didn't collect retirement income between 20% and 30% less than your annual work-based salary, though, you'd be an exception to the norm. That will likely put you in a lower tax bracket, in fact. The good news is, this should be still be enough for you to live on.

There are a couple of additional things to think about before committing to one kind of account or the other, though.

First, yes -- the lower the top tax bracket you're in for any given tax year, the less in total as well as relative taxes you'll pay. And as was noted, most people will earn more money while they're working than they will in retirement via IRA distributions and (mostly) tax-free Social Security income. That's why the ordinary/traditional IRA is the smarter choice for most investors, despite the obvious appeal of tax-free IRA withdrawals in retirement.

A true, dollar-for-dollar, apples-to-apples comparison, however, would assume you're also constructively investing your tax savings while you're working, growing this savings outside of your retirement account. Most people aren't doing this; many households just can't. If they were/could, they'd be at least a little better off in retirement by virtue of holding assets that can be accessed without any particular tax concern.

So, if you're not investing the tax savings, the net benefit of a contributory IRA isn't as meaningful.

The other consideration is the state you live in. Most states don't tax Social Security income, and nine don't tax retirement income simply because they don't impose any income tax on any resident (Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming).

Most states do, however, tax at least a portion of your retirement income from IRAs. Illinois, Iowa, Mississippi, and Pennsylvania are noteworthy exceptions. These four states don't tax IRA withdrawals and most pension income, even though they do impose state-based income tax.

Moving from one state to another can make a difference in how much of your money you're allowed to keep while you're working and saving, versus how much you keep once you're living on your retirement savings. If you were planning on moving from a state that taxes work-based wages to a state that doesn't tax retirement income, there's a case to be made for funding an ordinary IRA in your working years and then sidestepping state taxes on withdrawals from that retirement account (and vice versa for Roths).

Just consider potential changes in your cost of living if you're thinking of moving. On a net basis, you may not be any better off.

Either is likely fine, but both are an option too

But you're still suffering from analysis paralysis? Or maybe you're afraid you've already made the wrong choice based on a less-than-clear vision of your future? You haven't.

The fact is, choosing a Roth over a traditional IRA or a traditional IRA over a Roth can make a difference to your financial picture -- and ditto for a 401(k) -- but choosing the less optimal account is rarely devastating. Annoying and inconvenient? Perhaps a little. Maybe even measurably costly -- but hardly ruinous. The most devastating decision still remains doing nothing, and saving nothing.

If the choice has you stressed out, there's a simple solution: You can do both. Yes, you're allowed to contribute to both kinds of accounts in any given tax year. You just can't exceed the total allowable contribution limits between both types of accounts. This hedged option might be best for most investors, in fact, offering the most future flexibility when it comes to taking distributions.

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